Wednesday, 31 July 2013

Time to rethink inflation?

Inflation has been
made into a bit of a monster by economists but does inflation deserve its bad
name?

Inflation is seemingly innocuous and a bit boring. Prices go
up over time without hardly anybody noticing or being able to do anything. But the experiences of stagflation, when the
economy stagnated but inflation was stubbornly high in the 1970s, made
inflation public enemy number one for economists. Even though the global financial crisis has
shown that there are far worse gremlins lurking in the economy, worries about
inflation are hardwired into the way economists look at the world. Does inflation still matter or should central
banks be keeping their eyes out for something else?

Inflation has been targeted by policy makers since the 1970s
when economies in the West were plagued by high inflation and slow economic
growth amid the effects of the oil shocks.
Inflation became a central part of a downward economic spiral – rising
prices for consumer products due to oil being more costly prompted unions to
demand higher pay which pushed up the costs for firms, to which they responded
with increasing the prices of their goods. The negative impact of rising prices
and wage increases in combination with the higher cost of oil devastated the
economy and created a link between economic stagnation and inflation – hence
the term “stagflation”. A turnaround
came on the back of the unions losing their power to influence wage
negotiations after standoffs with Margaret Thatcher in the UK and Ronald Regan
in the US. But inflation is the boogie
man than has given a generation of economists nightmares.

The trauma of stagflation was powerful enough for
politicians to give up control of monetary policy to independent banks which
was seen as the best means by which to keep the beast of inflation in its
cage. This policy has been successful in
that inflation has remained subdued over the past two decades with expectations
of low inflation translating into only incremental increases in wages. This new policy was aided by the development
of China as source of cheap labour and an exporter of low cost goods which
limited increases in both prices and wages.
Despite achieving what it set out to do, the new policy framework also
created new problems.

Central banks have focused on slaying the beast that is
inflation but choose to ignore higher prices in other areas such as assets like
houses or stocks. Higher prices for
assets have the potential to develop into asset price bubbles which when popped
can have a devastating effect as shown by the global financial crisis. Whether it be because asset price bubbles are
not always easy to spot and this would create considerable subjectivity in
policy making, central banks have typically shied away from acting to prevent
the build-up of asset price bubbles.
Inflation in terms of prices of consumer goods is easier to measure and
develop a consensus on the correct policy measures but this may be a case of
slaying one dragon only to let a bigger one roam free.

Your Neighbourhood Economist would argue that inflation is
not the scourge that it once was. Relentless
increases in wages as in the 1970s are not likely to occur as unions do not
have anywhere near the same power as before and also because competition from
workers in China and elsewhere means that average wages in Western countries
have hardly seen any increases at all.
So the past lessons from stagflation do not seem so pertinent any
more. The global financial crisis
occurred at a time of low inflation but following a period of excessive lending
by banks spurred on by low interest rates set by central banks.

This does not mean that inflation is something that should
be let loose again. Rising prices eat
away at what workers can afford to purchase with their wages and they will be
able to buy less with their savings that are stashed away if prices are
increasing. Inflation in one country
also increases the costs used to produce goods in that country and makes it
less competitive relative to goods made elsewhere. But to have monetary policy revolve around
something that has only a minimal effect on the overall economy is out-of-date
and potentially hazardous. Inflation may
also be a route to salvation for Western countries buried under high levels of
debt – it is easier to pay back loans if wages and tax revenues are increasing
(for more on inflation as a power for good, see What's up with inflation?). It will take a lot for economists to admit
that they have gotten side-tracked by an infatuation with inflation, but the
aftermath of a near economic collapse seems as good a time as any to do so.

2 comments:

Quote: "it is easier to pay back loans if wages and tax revenues are increasing." You omit to add: "and when the poor saps who lent you the money are repaid in devalued currency....." Good ole 'Stealth Default' in other words, not a phrase I'm expecting to see used very much in your articles.

The easiest way of getting rid of excess debt is to using a devalued currency. The other option - an economy saddled with heavy debt repayments - is worse even for people without any debt considering the negative effects of government austerity and weak consumer spending.

The real problem is that quantitative easing has not worked as well in moving toward a stealth default as was probably hoped. Greece would also like to use the stealth default option and would probably do so if it still had its own currency. A real default would be a lot worse.

So a stealth default is not actually deserving of the negative implications. Anybody with objections can always move their money into a more stable currency or other forms of wealth so the losses can even be mitigated. Almost sounds like good policy to me....